3 Things You Didn't Know About Costco

Warehouse giant Costco (NASDAQ: COST) was founded in 1983 in Seattle, Washington. Since its early days the company has grown to nearly six-hundred fifty locations, competing directly with Wal-Mart's (NYSE: WMT) Sam's Club stores.

Understanding Costco's underlying business is the best way to decide if you should buy the stock now. Here are three things you didn't know about Costco.

Image courtesy of Costco

Costco doesn't make scratch on chicken'sCustomer's love Costco's super cheap rotisserie chicken's, the company sells over 60 million a year, but did you know Costco makes next to nothing on them? The same holds true for almost everything you buy in Costco; the entire business model is based on selling goods at pencil thin margins.

Costco makes the overwhelming majority of its profit on up-front membership fees. The idea is that once members sign-up, they'll be so delighted by the low costs that they'll happily stay members for years. If you're considering Costco's stock you should be aware of this. The last thing you want to do, is panic about this strategy after a bad quarter.

Costco's high wages may help the bottom lineCostco employee's are very well paid compared to traditional retailers. The average cashier at Costco is paid in the teens, as opposed to closer to $9/hr for Wal-Mart. Overall, the average Costco employee makes over $20/hr, while the average Wal-Mart employee makes a little over $12/hr. On the surface this would seem like an unnessary cost for Costco, yet the stock has delivered superior returns. Why?

The answer is that the cost of investing in employees, tends to pay outstanding dividends in retail. The biggest costs that Costco avoids are related to employee turnover. The overall turnover rate for retail is somewhere in the neighborhood of 25%. In a interview with Jim Sinegal, Motley Fool CEO Tom Gardner learned that Costco's turnover is less than 10%. By having lower turnover, Costco spends less time with under staffed stores, which leads to less overtime expenses. It also has to spend less on hiring, both advertising for new positions and training, thanks to low turnover. Add in the good PR, and side stepping labor disputes, and you can see why Costco's gone this route.

Finally there is a loyalty effect that is less tangible, but equally as important. Employee's who work for Costco for years, and feel fairly treated, tend to provide better customer service. They feel invested in the company.

Costco is trying to read your mindIn the CNBC Documentary "Costco Craze: Inside the Warehouse Giant" we saw just how much of a role psychology plays in Costco's strategy. Brian Wansink, a Consumer Behavior Professor from Cornell University, explained that "when a business is membership based, impulse buying happens more frequently." Because of the nature of Costco's business members may feel an urge to buy more than they need to justify membership costs, or simply because everything is sold in bulk. The unique experience of "scoring deals" actually leads customers to buy more as well.

What Costco does to capitalize on this is truly unique. About 75% of its merchandise is staples, such as cereal or pasta and the remaining 25% is what Costco calls "treasures." The treasures are flashy items such as high-end electronics and even price slashed wedding dresses; they're aimed at keeping the Costco experience unique.

So Costco's sales process is two-step. They get you committed to looking for a great deal early on, and then they hook you with their "treasures." This has the tendency to delight customers.

Costco is differentCostco does things its own way, usually with terrific results. It sells products at razor thin margins, but delights customers so much that it doesn't need to spend on advertising. In the end, it's a delightfully effective business. With that said, you should take time learning more about all the nuances of the business before you buy the stock.

Hopefully, these three facts will help you get started.

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